When it comes to protecting aluminium consumers from price volatility, call options are a commonly used tool. But the reasoning behind buying a call option as a hedge is often misunderstood. In this episode of Hedging with Jorge, we break down how and why aluminium consumers use call options to safeguard against price hikes.

Buying a call- The aluminium consumer’s perspective

Let’s consider an example, we are aluminium consumers who need protection in case prices go higher. Suppose we buy a call option with a strike price of $2,700 and pay a $100 premium. This $100 premium is not small, it represents a significant cost.

Why would we pay for it? Because we expect the market to go down, ideally by at least the premium paid. We buy this protection just in case prices rise unexpectedly. If aluminium prices do move higher, we will exercise the call. But then comes the regret, we’ve spent a hefty premium when buying futures could have offered full protection without that upfront cost.

Call options vs. Futures – Different mindsets

When you use call options as a hedge for your short aluminium exposure or long-term consumption needs, you do so with a bearish market outlook. You hope prices will go down, at least enough to cover the premium. But you still want protection just in case.

Contrast this with a speculator who buys a call. The speculator’s expectation is the opposite they believe the market will go much higher than the premium paid.

So, while both are buying calls, the motivations differ drastically:

The speculator expects strong upward movement.

The consumer (hedger) hopes for price stability or even decline but buys protection just in case prices rise.

Think of it like insurance

To make this clearer, buying a call as a hedge is like purchasing car insurance. You pay the premium, but you hope you never have to use it. You don’t buy insurance expecting to crash your car, you buy it to protect against that possibility.

In hedging with calls, if nothing happens if aluminium prices don’t spike the premium is a loss. But it was a necessary cost for peace of mind. This analogy perfectly captures the purpose of call options for aluminium consumers.

Key takeaway

The decision to invest in call options as a hedge comes from a bearish or stable market outlook combined with the need for protection. You are not betting on higher prices you are simply safeguarding your business against unexpected market movements, much like how insurance works in everyday life.